1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 17 Chapter Public Finance: The Economics of Taxation

2. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 35 Chapter Outline 17 Public Finance: The Economics of Taxation The Economics of Taxation Taxes: Basic Concepts Tax Equity What Is the “Best” Tax Base? The Gift and Estate Tax Tax Incidence: Who Pays? The Incidence of Payroll Taxes The Incidence of Corporate Profits Taxes The Overall Incidence of Taxes in the United States: Empirical Evidence Excess Burdens and the Principle of Neutrality How Do Excess Burdens Arise? The Principle of Second Best Measuring Excess Burdens Excess Burdens and the Degree of Distortion

3. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 35 PUBLIC FINANCE: THE ECONOMICS OF TAXATION Taxes may be imposed on transactions, institutions, property, meals, and other things, but in the final analysis they are paid by individuals or households. No matter what functions we end up assigning to government, to do anything at all government must first raise revenues. The primary vehicle that the government uses to finance itself is taxation.

4. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 35 THE ECONOMICS OF TAXATION tax base The measure or value upon which a tax is levied. TAXES: BASIC CONCEPTS tax rate structure The percentage of a tax base that must be paid in taxes—25 percent of income, for example.

5. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 35 THE ECONOMICS OF TAXATION Taxes on Stocks versus Taxes on Flows FIGURE 17.1 Taxes on Economic “Flows”

6. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 35 THE ECONOMICS OF TAXATION TABLE 17.1 Federal Government Receipts 1960–2005 (billions of dollars) Individual Income Tax Corporation Income Tax Social Insur. Payroll Taxes Excise Taxes Other ReceiptsTotal 196040.721.514.711.73.992.5 %44.023.215.912.64.2100 197090.432.844.415.79.5192.8 %46.917.023.08.14.9100 1980244.164.6157.824.326.3517.1 %47.212.530.14.75.1100 1990466.993.5380.035.356.21,032.0 %45.29.136.83.45.4100 2005*893.7226.5773.774.084.82053.0 %43.511.037.73.64.1100 * OMB estimate Source: United States, Office of Management and Budget. Percentages may not add to 100 due to rounding.

7. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 35 THE ECONOMICS OF TAXATION Proportional, Progressive, and Regressive Taxes proportional tax A tax whose burden is the same proportion of income for all households. progressive tax A tax whose burden, expressed as a percentage of income, increases as income increases.

8. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 35 THE ECONOMICS OF TAXATION regressive tax A tax whose burden, expressed as a percentage of income, falls as income increases. TABLE 17.2 The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households with Different Incomes HOUSEHOLD SAVING INCOME RATE, %SAVINGCONSUMPTION 5% TAX ON CONSUMPTION TAX AS A % OF INCOME A$ 10,00020$ 2,000$ 8,000$ 4004.0 B20,000408,00012,0006003.0 C50,0005025,000 1,2502.5

9. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 35 THE ECONOMICS OF TAXATION Marginal versus Average Tax Rates average tax rate Total amount of tax paid divided by total income. marginal tax rate The tax rate paid on any additional income earned.

10. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 35 THE ECONOMICS OF TAXATION TABLE 17.3 Individual Income Tax Rates, 2005 MARRIED COUPLES FILING JOINTLY TAXABLE INCOMETAX RATE $0 - 14,60010% $14,601 – 59,40015% $59,401 – 119,95025% $119,951 – 182,80028% $182,801 – 326,45033% More than $326,45035% SINGLE TAXPAYERS TAXABLE INCOMETAX RATE $0 – 7,30010% $7,301 – 29,70015% $29,701 – 71,95028% $71,951 – 150,15033% $150,151 – 326,45035% Source: The Internal Revenue Service.

11. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 35 THE ECONOMICS OF TAXATION TABLE 17.4 Tax Calculations for a Single Taxpayer Who Earned $100,000 in 2005 Total income$100,000  Personal exemption $3,200  Standard deduction $5,000 = Taxable income$91,800 Tax Calculation 0 - $7,300 taxed at 10% > $7,300 X.10 = $730 $7,300 - $29,700 taxed at 15% = ($29,700 – $7,300) X.15 = $22,400 X.15 = $3,360 $29,700 - $71,950 taxed at 25% = ($71,950 – 29,700) X.25 = $42,250 X.25 = $10,562 Income above $71,950 taxed at 28% = ($91,800 - $71,950) X.28 = $19,850 X.28 = $5,558 Total tax $20,210 Average tax rate 20.2% Marginal tax rate 28%

12. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 35 THE ECONOMICS OF TAXATION How Much Does a Deduction Save You in Taxes? Marginal tax rates influence behavior. Decisions about how much to work depend on how much of the added income you get to take home. Similarly, a firm’s decision about how much to invest depends in part on the additional, or marginal, profits that the investment project would yield after tax. Taxpayers may deduct income taxes paid to a state, charitable contributions to qualifying organizations, real estate taxes, and interest paid on a mortgage to finance the purchase of a home, as well as other items.

13. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 35 THE ECONOMICS OF TAXATION TAX EQUITY benefits-received principle A theory of fairness holding that taxpayers should contribute to government (in the form of taxes) in proportion to the benefits that they receive from public expenditures. ability-to-pay principle A theory of taxation holding that citizens should bear tax burdens in line with their ability to pay taxes.

14. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 35 THE ECONOMICS OF TAXATION Horizontal and Vertical Equity If we accept the idea that ability to pay should be the basis for the distribution of tax burdens, two principles follow. First, the principle of horizontal equity holds that those with equal ability to pay should bear equal tax burdens. Second, the principle of vertical equity holds that those with greater ability to pay should pay more.

15. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 35 THE ECONOMICS OF TAXATION WHAT IS THE “BEST” TAX BASE? The three leading candidates for best tax base are income, consumption, and wealth. Income—to be precise, economic income—is anything that enhances your ability to command resources. Economic Income = Consumption + Change in Net Worth In economic terms, income is income, regardless of source and use.

16. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 35 THE ECONOMICS OF TAXATION Consumption is the total value of things that a household consumes in a given period. Wealth, or net worth, is the value of all the things you own after your liabilities are subtracted. Net worth = Assets − Liabilities

17. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 35 THE ECONOMICS OF TAXATION Consumption as the Best Tax Base Thomas Hobbes argued that people should pay taxes in accordance with “what they actually take out of the common pot, not what they leave in.” Alex’s orchard.

18. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 35 THE ECONOMICS OF TAXATION Income as the Best Tax Base Wealth as the Best Tax Base According to proponents of income as a tax base, you should be taxed not on what you actually draw out of the common pot, but rather on the basis of your ability to draw from that pot. Still others argue that the real power to command resources comes not from any single year’s income but from accumulated wealth. No Simple Answer There is ongoing debate in the United States about whether it would be better to shift toward a more comprehensive consumption tax.

19. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 35 THE ECONOMICS OF TAXATION THE GIFT AND ESTATE TAX estate The property that a person owns at the time of his or her death. estate tax A tax on the total value of a person’s estate.

20. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 35 TAX INCIDENCE: WHO PAYS? tax incidence The ultimate distribution of a tax burden. sources side/uses side The impact of a tax may be felt on one or the other or on both sides of the income equation. A tax may cause net income to fall (damage on the sources side), or it may cause prices of goods and services to rise so that income buys less (damage on the uses side). The imposition of a tax or a change in a tax can change behavior. Changes in behavior can affect supply and demand in markets and cause prices to change. When prices change in input or output markets, some households are made better off and some are made worse off. These final changes determine the ultimate burden of the tax.

21. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 35 TAX INCIDENCE: WHO PAYS? tax shifting Occurs when households can alter their behavior and do something to avoid paying a tax. Broad-based taxes are less likely to be shifted and more likely to “stick” where they are levied than “partial taxes” are.

22. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 35 TAX INCIDENCE: WHO PAYS? THE INCIDENCE OF PAYROLL TAXES FIGURE 17.2 Equilibrium in a Competitive Labor Market—No Taxes

23. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 35 TAX INCIDENCE: WHO PAYS? Imposing a Payroll Tax: Who Pays? FIGURE 17.3 Incidence of a Per-Unit Payroll Tax in a Perfectly Competitive Labor Market

24. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 35 TAX INCIDENCE: WHO PAYS? FIGURE 17.4 Payroll Tax with Elastic (a) and Inelastic (b) Labor Supply Workers bear the bulk of the burden of a payroll tax if labor supply is relatively inelastic, and firms bear the bulk of the burden of a payroll tax if labor supply is relatively elastic. Most of the payroll tax in the United States if probably borne by workers.

25. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 35 TAX INCIDENCE: WHO PAYS? TABLE 17.5 Estimated Incidence of Payroll Taxes in the United States in 2003 POPULATION RANKED BY INCOME TAX AS A % OF TOTAL INCOME Bottom 20%7.6 Second 20%9.8 Third 20%10.7 Fourth 20%11.2 Top 20%8.0 Top 10%6.7 Top 5%5.3 Top 1%3.0 Source: Authors’ estimate.

26. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 35 TAX INCIDENCE: WHO PAYS? THE INCIDENCE OF CORPORATE PROFITS TAXES corporations Firms that are granted limited liability status by the government. Limited liability means that shareholder/owners can lose only what they have invested.

27. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 35 TAX INCIDENCE: WHO PAYS? The Burden of the Corporate Tax Owners of corporations, proprietorships, and partnerships all bear the burden of the corporate tax in rough proportion to profits, even though it is directly levied only on corporations. TABLE 17.6 Estimated Burden of the U.S. Corporation Income Tax in 2004 POPULATION RANKED BY INCOME TAX AS A % OF TOTAL INCOME Bottom 20%0.5 Second 20%1.0 Third 20%1.4 Fourth 20%1.5 Top 20%4.5 Top 10%5.7 Top 5%7.2 Top 1%9.7 Source: Authors’ estimate.

28. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 35 TAX INCIDENCE: WHO PAYS? THE OVERALL INCIDENCE OF TAXES IN THE UNITED STATES: EMPIRICAL EVIDENCE State and local taxes (with sales taxes playing a big role) seem as a group to be mildly regressive. Federal taxes, dominated by the individual income tax but increasingly affected by the regressive payroll tax, are mildly progressive. The overall system is mildly progressive. Many researchers have done complete analyses under varying assumptions about tax incidence, and in most cases their results are similar:

29. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 35 EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY When taxes distort economic conditions, they impose burdens on society that in aggregate exceed the revenue collected by the government. excess burden The amount by which the burden of a tax exceeds the total revenue collected. Also called deadweight loss. principle of neutrality All else equal, taxes that are neutral with respect to economic decisions (that is, taxes that do not distort economic decisions) are generally preferable to taxes that distort economic decisions. Taxes that are not neutral impose excess burdens. Ceteris paribus, or all else equal, a tax that is neutral with respect to economic decisions is preferred to one that distorts economic decisions.

30. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 35 EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY FIGURE 17.5 Firms Choose the Technology That Minimizes the Cost of Production HOW DO EXCESS BURDENS ARISE?

31. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 35 EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY The larger the distortion that a tax causes in behavior, the larger the excess burden of the tax. Taxes levied on broad bases tend to distort choices less and impose smaller excess burdens than taxes on more sharply defined bases. FIGURE 17.6 Imposition of a Tax on Capital Distorts the Choice of Technology

32. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 35 EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY At least two kinds of circumstances favor nonneutral (that is, distorting) taxes: the presence of externalities and the presence of other distorting taxes. THE PRINCIPLE OF SECOND BEST principle of second best The fact that a tax distorts an economic decision does not always imply that such a tax imposes an excess burden. If there are previously existing distortions, such a tax may actually improve efficiency. Optimal Taxation The idea that taxes work together to affect behavior has led tax theorists to search for optimal taxation systems.

33. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 35 MEASURING EXCESS BURDENS FIGURE 17.7 The Excess Burden of a Distorting Excise Tax

34. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 35 MEASURING EXCESS BURDENS The more elastic the demand curve, the greater is the distortion caused by any given tax rate. EXCESS BURDENS AND THE DEGREE OF DISTORTION FIGURE 17.8 The Size of the Excess Burden of a Distorting Excise Tax Depends on the Elasticity of Demand

35. CHAPTER 17: Public Finance: The Economics of Taxation © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 35 ability-to-pay principle average tax rate benefits-received principle excess burden corporations estate estate tax marginal tax rate principle of neutrality REVIEW TERMS AND CONCEPTS principle of second best progressive tax proportional tax regressive tax sources side/uses side tax base tax incidence tax rate structure tax shifting